We expect the U.S. economy to grow only about 2% in the first quarter but see a potentially substantial rebound in the second quarter, which might make it the best performing quarter of the year.

Is Fed Chair Janet Yellen the reincarnation of Teddy Roosevelt---"Walk softly but carry a big stick?"

Our Investment Strategy Team met this week and affirmed the broad weightings of our model asset allocation strategies.1 As depicted in Figure 1, we are overweighted, relative to our benchmarks, in equities. We are underweighted in fixed income securities—nominal bonds and cash equivalents combined. We are especially light on core bonds, such as U.S. Treasuries and investment-grade corporate and municipal debt.

However, within our domestic equity allocations, we decided to move from a balanced split between value and growth large-cap equities to an allocation that favors growth over value by a 75%/25% split. We retain our half-of-benchmark stakes—5% versus 10% in all strategy models—in inflation hedges, which include inflation-linked bonds and commodity- and real estate-related securities.

U.S. Economy Ready to Shake off the Winter Doldrums
Our expectations for 2014 have not changed much in the past month and remain fairly positive because the economy is expected to expand and economic behavior should normalize further as the financial crisis fades. Current economic conditions are being impacted by an unusually harsh winter in the United States as well as by uncertainties surrounding emerging market economies. Real GDP growth in the first quarter of 2014 is expected to be near 2% as the winter weather will have a negative impact on consumption spending, housing investment, and reduced inventory accumulation. However, we expect the economy to rebound during the second quarter with real GDP growth likely to be near 3.0%. This could turn out to be the strongest quarter of the year. We expect growth to moderate towards the 2.5-3.0% range over the remainder of 2014.

The most recent employment report provided a positive boost after two months of below-par reports. While job growth has not returned to the levels of 2013, job gains might have been significantly higher were it not for the winter weather impacting a larger than normal number of workers. We expect the unemployment rate to continue to migrate lower throughout the year with the prospect that it could reach close to 6.0% by the end of the year.

The housing market recovered nicely in 2013 and this recovery should extend into 2014, although we might not see the same magnitude of gains. Housing starts moved up late in the year despite concerns that the government shutdown would hamper activity. Overall homebuyer affordability remains at very attractive levels; the average potential homeowner has slightly over 160% of the financial capacity needed to buy a median-priced home.

On the international front, global expansion is still expected to be the theme of 2014, but there are numerous reasons for investors to temper their outlook. We expect Europe to continue its recovery, largely driven by gains in Germany, but we cannot rule out the possibility of needing further assistance from the European Central Bank. Bank lending is still heavily constrained and it will be difficult for growth to pick up if businesses have difficulty finding financing. The crisis in Ukraine has added a new dimension to the European outlook. A significant escalation of sanctions could endanger the supply of energy resources coming from Russia into Europe, as well as the flow of Western capital into Russia. Such an outcome could plunge both parties into a deep economic slump. At this point, it seems Western governments have little stomach for a major confrontation which would lead to a limited economic impact. Russia appears to be trying to position Ukraine as a standalone neutral entity that would never enter the EU or NATO in exchange for remaining "independent" but effectively heavily tied to the Russian sphere of influence.

The Japan economy will grow more slowly in 2014 than it did in 2013. The verdict on Abenomics is not complete as concerns center on the negative impacts Abenomics may be having on consumer spending, which could be further compromised by the pending Value Added Tax (VAT) increase. We expect the growth rate in China to decelerate as the economy shifts from investment to more consumption spending. In addition, Chinese authorities are wrestling with trying to gain better control of the shadow banking system, thwart corruption, and reduce pollution, all efforts that could further restrain growth. Emerging markets continue to struggle. In some cases, this has led to violence. For many emerging market countries, the prospect of not having cheap foreign capital inflows is presenting a challenge that likely will not be solved quickly. While this situation will not impact all emerging market countries, contagion impacts cannot be ruled out.

Solidly in the Domestic Equity Growth Camp
Our style allocation in small-cap U.S. equities has favored growth stocks over value stocks for several months and we have now added the top tier capitalized securities to the same bias. The reasons behind this start with our proprietary models, which indicated a shift from neutral to favoring growth. This was further supported by a number of factors stemming from our outlook which should benefit growth stocks. We expect that 2014 will show stronger gains in capital spending, which should favor industrials and technology firms. In addition, as the unemployment rate drops, we should see further gains in consumer discretionary spending, helping that sector as well. Given the problems in emerging markets, we see limited upside in the energy, materials (metals and mining), and utility sectors, which might hinder the value side. While we generally like financials, improvements here are likely to be a longer-term story. Financials might be held up by a significant regulatory burden.

Janet Yellen---"Rough Rider?"
Newly minted Fed Chair Janet Yellen oversaw her first Federal Open Market Committee meeting this week and held her first post-meeting press briefing as well. Markets got a bit more than they expected! On the one hand, Dr. Yellen was quick to point out that the Fed was sticking to its no-tightening approach as long as the economy remained inflation light—"walking softly" as it were— but she made it clear that the Fed would be ready to raise short-term rates decisively and possibly sooner than the market had expected Thus she is "carrying a big stick" and seems not afraid to use it! Perhaps the biggest new piece of information was her view that the "considerable period" between the end of the quantitative easing program and the start of short-term interest rate hikes might be only six months, which points to a second quarter 2015 startup given current trends. Fixed income markets in particular began to adjust to this with interest rates moving higher. Understanding what will move the Fed is not much clearer
than before, and we are not certain if particular data levels will drive policy or if it will be calendar parameters, such as the six-month window revealed yesterday. Inflation does appear to be more of a factor than previously thought; many feared Dr. Yellen would not value inflation as much as the unemployment statistics. The 2% inflation target appears to be an important threshold, and as long as price increases fall below this rate, short-term interest rates are likely to stay put. Regardless, as the economy improves, the normalization process should include re-establishing real rates of return across the yield curve, a move the new Fed Chair made clear she is willing to make without hesitation. As we noted before, we see these steps as important and necessary to re-establish market equilibriums distorted by the financial crisis, and while markets may cringe, they are steps that should ultimately be viewed positively and support financial gains.

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